Fundamentals: A Deep Dive On Debt
Understanding how corporate debt works is critical for equity investors
This is another installment of our Fundamentals series, which aims to explain investing concepts. In this piece we will:
Discuss the different types of debt available to companies.
How the choice of debt can impact equity value.
Why it’s important to understand not just how much debt a business has, but also, what type of debt it is.
This will be the first of a multi-part series and you may also wish to read our piece looking at the risks and rewards of financial leverage for equity investors.
The Different Kinds Of Corporate Bonds
Corporate debt can vary in multiple ways:
who the lender(s) is/are;
what the interest rate is and how it is calculated;
what assets are secured by the debt;
when and how much money is borrowed; and when and under what terms that money is repaid.
The dizzying array of options exists because different companies have different needs as they mature (and like so much else in finance, because a wider offering of products usually means higher fees for the investment banks pitching those products).
Source: AT&T cover page from 10-Q listing most of the company's exchange-listed bonds
Public corporations can raise debt from multiple sources. Corporate bonds are sold to investors via an investment bank (or a consortium of investment banks), known as the underwriter. In the U.S., some bonds fall under Rule 144a of the Securities and Exchange Commission, meaning they can only be sold to qualified institutional buyers. Others can be owned by retail investors via most brokerages.
In most cases1, corporate bonds have a fixed maturity date — the date at which the borrowed funds must be repaid — though some bonds can be ‘called’ by the issuer ahead of time. Pretty much every bond has to be repaid upon an acquisition or other “change in control”, often at a premium. Bonds can be secured by all or some of a company’s assets, or be unsecured.
They include covenants, which restrict the company from certain activities. Some covenants can be somewhat harsh: they might, for instance, preclude the company from issuing any additional debt at all. Others are more boilerplate, preventing the company from moving assets to other subsidiaries, or spinning off or selling part of the business without triggering bond redemption.
Bonds generally have a fixed interest rate, or ‘coupon’. (There are a few bonds with a floating interest rate tied to specific benchmarks, but those are rare). Interest is usually paid every six months. And when the bonds mature, the company repays funds to the current bondholders, which quite often are not the same investors who bought the bonds when they were issued.
Some corporate bonds are convertible bonds. Convertible bonds can be repaid either in equity or in stock. In rare circumstances, it’s up to the company to choose; if the company elects to repay in stock, they almost always have to issue those shares at a discount to the price at the time2. The standard structure, however, is that bondholders are paid in stock if the stock trades above a certain conversion price.
That conversion price is usually higher than the stock price at the time of issuance: a company might issue a $1,000 bond convertible for 50 shares while its stock trades at $12. If the stock clears the $20 conversion price3, the bondholder can convert into shares; if not, she is repaid $1,000 at maturity.
This sounds like an awful deal for the company, which is either repaying debt or issuing equity at a discount. But the benefit to the borrower is a lower interest rate4. In 2021, in particular, amid a hot equity market and rock-bottom interest rates, many companies were able to issue zero-coupon convertibles. More than a few got excellent deals. Snap SNAP 0.00%↑ has a zero-coupon convertible due in 2027 with a conversion price above $89; the stock currently trades at just $16.
Most corporate bonds are issued in increments of $1,000. But so-called “baby bonds” are offered in smaller increments (often $25), in large part because they are actually designed to be owned by individual investors (and traded on exchanges). Baby bonds are often issued by companies looking to raise smaller amounts of capital. Generally, telecom companies, financials, and BDCs (business development companies, which invest in the debt and/or equity of other companies) are the most common baby bond issuers, though here too there are exceptions.
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Bank Debt and Private Credit
But companies can also borrow directly from banks or, nowadays, alternative lenders that supply what is known as “private credit”5. Those borrowings take different forms. A term loan mimics a bond: the company borrows a set amount of money, and must repay it at the maturity date. But term loans are much more likely than bonds to have floating interest rates, usually defined by a “spread” to the Secured Overnight Funding Rate, or SOFR6.
In contrast, a line of credit or a revolving credit facility (also known as a revolver) allows a company to borrow up to a specified limit — but unlike a term loan, the funds can be drawn (and, usually, repaid) at the company’s discretion. There are obvious parallels in consumer debt: a term loan is akin to a personal loan, while a revolver is like a credit card. In the former arrangement, a preset amount of money is borrowed up front; in the latter, the borrower has discretion to borrow, up to a preset limit. (Both companies and consumers can access lines of credit, of course, and real estate investment trusts do take out mortgages against their properties.)
Unlike bonds, these borrowings are owed to either a single institution or, sometimes, a syndicate of institutions. These loans can be traded, but not on public markets and certainly not to individual investors. Covenants can be much more restrictive; some term loans include restrictions on EBITDA7 performance. If the company fails to meet those targets, the lender can force a default and eventually take control of the company, zeroing out shareholders in the process.
And usually bonds have a longer maturity schedule: in 1993, both Disney DIS 0.00%↑ and Coca-Cola KO 0.00%↑ issued 100-year bonds. Maturities of seven years or longer are more common for bonds. Shorter-dated borrowing is usually bank debt of some kind. A specific company’s borrowings and their terms are detailed in 10-K filings with the SEC. Exhibits to the 10-K often include the actual credit agreements themselves.
Why Companies Choose Different Debt (Or Debt At All)
For any corporate borrowing, then, there are a myriad of considerations. How long should be the maturity be? How much money should be borrowed relative to either the market capitalization and/or to EBITDA and free cash flow? What interest rate is acceptable? Is a convertible issue preferable?
Some of these decisions are made for the company. For instance, smaller companies usually can’t issue traditional corporate bonds, since they’re simply not big enough. A $10 million bond issue doesn’t work for the issuer, which will see a big chunk of the proceeds lost to expenses. It doesn’t work for buyers, either: those buyers want the ability to sell the bonds if necessary, but such a tiny issue will have very thin liquidity8. And so direct lending, either via a bank or an alternative credit provider, is often the only option. Conversely, a massive company can have a revolver or even a bank loan, but those offerings won’t be large enough to fund all of their needs. No bank will be willing to take on that amount of company-specific risk.
Generally speaking, within the menu of choices there are some rules. Obviously, the lower the interest rate, the better — and even that rate is a tell. If U.S. Treasury bonds that mature in seven years yield 4%, and a company can issue seven-year debt at 5%, that is a sign that the credit markets view the company as rather stable. (We’ll discuss the importance of interest rates in much more detail in the second part of this series.)
The longer the maturity, the better. This, too, is a tell: if bond investors are willing to lend to a company for decades, it by definition means those investors believe the company will exist decades from now. That aside, longer-dated maturities are usually more attractive because they can create a no-lose proposition for the issuer. If interest rates go up, the company has locked in cheaper financing than it would have otherwise received. If they go down, the company can sometimes refinance (if the bond is callable).
For similar reasons, fixed-rate issuance is preferable. It also gives management clarity as to expenses in the future. This can be accomplished in floating-rate debt, however, by hedging interest rates through a so-called interest rate swap. In a swap, an issuer gets paid if rates go up (and pays if they go down), meaning that higher or lower expense on floating debt is mostly offset by profit or loss on the hedge.
But beyond those broad rules, the choice of debt by a company can provide valuable information. A revolver, for instance, can be set up simply for optionality: in case an attractive acquisition pops up, or if management sees a plunging share price as an opportunity for stock buybacks. There is a fee for unused capacity, but it’s usually quite small (less than 1%), and so an entrance into a revolving credit facility is not necessarily a sign that a company has big plans.
A term loan, however, is different. Again, term loan funds are delivered in full immediately — and interest begins accruing immediately. Companies have to disclose the use of proceeds for the loan, and usually provide detail to investors, but sometimes the boilerplate of “general corporate purposes” is used. In that scenario, investors have to suss out the actual motivation. Is the company looking to make a big acquisition or add a new plant? To alter its capital structure by increasing debt and buying back equity? Or is it worried about a potential cyclical downturn?9
Similarly, the choice to issue a convertible, and on what terms, provides information. In some cases, the convertible route is simply a matter of financial engineering to get a lower effective rate10. But a convertible bond, particularly without a hedge, shows a management team willing to essentially trade equity upside for interest savings, which in turn suggests some caution from that team toward the stock price.
Debt Is Complicated
This all sounds incredibly complicated — and perhaps needlessly complicated. Consumers make do with just a handful of credit products; surely companies can do the same.
But the complication exists because, for corporations, debt has many different purposes. It can be used to fund new factories, or to fund acquisitions. It can simply add a bit of leverage for equity holders. If a company can borrow at 5% to repurchase shares in a business whose value increases 10% annually, the remaining shareholders quite obviously benefit.
Borrowing capacity on a revolver or line of credit can be used to act quickly if opportunities arise — or, in some cases, to assure existing investors that the company’s financial situation is secure. If, for instance, the economy turns south and orders dry up, the company can simply draw funds from its revolver while it waits for the external environment to improve.
The good news for equity investors is that the complicated details themselves aren’t that important. It’s credit investors who need to understand the vagaries of first- and second-lien debt, or the recovery value in a bankruptcy implied by a current yield on a corporate bond. For equity investors, debt analysis often boils down to common sense.
For instance, if a company is issuing debt at 11% in the current environment, that is clearly a sign that the credit markets see some risk. If it’s issuing a convertible at a low premium, that suggests either management that is pessimistic toward the stock price or a market that is unwilling to offer better terms. If a company is in danger of tripping EBITDA covenants, that dramatically increases risk, whether of an eventual restructuring or a hasty effort to sell an asset with little negotiating power. The maturity of a low-interest bond, assuming the company doesn’t have cash on hand to pay off the debt in full, likely means a necessary refinancing at a higher rate (and thus higher interest expense and lower profit).
The choice of lender certainly matters. Last week, we highlighted iRobot IRBT 0.00%↑, whose stock has plunged after its proposed takeover by Amazon AMZN 0.00%↑. One of the obvious risks in iRobot is its debt: not just the amount of debt, but the fact that it is owed to PE giant Carlyle Group CG 0.00%↑.
As we wrote then, Carlyle is a more dangerous lender than, say, a major bank. Its experience in actually running companies makes it much more likely to take a hard line with iRobot and potentially wind up with the business at the cost of simply writing off the loan. A major bank would not run the business, but instead be forced to sell it (here, too, with little negotiating power). Incentives thus lean toward giving the company more time. IRBT is literally a worse equity investment because of who it borrowed from11.
With experience, these issues become easier to spot and easier to understand. But the broad point is that equity investors need to understand more than just how much debt a company has. They need to understand what kind of debt a company has, too. In many cases, it honestly won’t matter. But, as we’ll discuss in future articles, when it does matter, it really matters.
As of this writing, Vince Martin has no positions in any securities mentioned.
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There are going to be exceptions somewhere for pretty much every discussion in this article, but the broad explanations should hold in the overwhelming majority of instances.
In practice, stock is worth less than cash, since the act of bondholders selling the shares received will likely push down the stock price.
The conversion feature often isn’t triggered until the price reaches a certain threshold for a set number of days.
Companies can also hedge their conversion risk by buying call options on their stock, usually at a price further above the conversion price. This results in a so-called “capped call” convertible.
As the name suggests, most private credit providers serve private companies, but they have made inroads in the public market as well. Their rise is due in large part to regulations enacted after the financial crisis which aimed to rein in risky lending by banks.
Earnings before interest, taxes, depreciation and amortization, which we discussed in this space in October.
All the permutations described here — and there are many more — mean that bonds are idiosyncratic instruments. Finding a buyer for a bond is thus much more difficult than it is for a share of stock, which is compounded by the fact that stock is traded much, much more frequently.
During the 2010s, there were times when issuing debt was almost too cheap not to do, particularly for U.S. companies selling bonds in foreign currencies to overseas investors. That time has passed, at least for now.
An oversimplified model: imagine a company can issue $1 billion in seven-year bonds at 10% interest. It will pay $700 million in total interest. Or the company can issue $1 billion in seven-year convertible bonds at 4% interest, and pay $200 million to hedge upside in the stock beyond the conversion price. In the latter framework, it’s paying $600 million total for the same amount of net proceeds.
Of course, it also likely borrowed from Carlyle precisely because its financial situation had become so precarious that traditional sources of funding were not available.